Portions adopted from Dimensional Fund Advisors November 2017 Issue Brief "Key Questions for the Long-Term Investor"
Do Ratings Matter?
“Many of our mutual funds earn Morningstar’s highest ratings,” reads the headline on a major mutual fund company’s website. They aren’t unique. Virtually every fund company references the Chicago based investment research firm’s rating system to promote their funds that have earned the coveted 4 or 5-Star ratings.
When you consider a new investment option in your 401(k) or where to put your next IRA contribution, chances are that you checked the star rating before making the selections. You’re not alone. In addition to individual investors, Morningstar’s own website says they are “a leading provider of independent research” to financial advisors, asset managers, retirement plan providers and sponsors, and institutional investors. But do the ratings help investors choose better funds?
A recent article in the Wall Street Journal (requires a subscription) casts doubt on the premise that more stars equates to better performance. The piece showed that since 2003, only 12% of funds initially rated 5-Stars performed well enough to retain the rating 5 years later. That was only marginally better than the 10% that were so bad that they earned only 1 star.
The moral of the story was that high star ratings are good for sales, but maybe not so much for investors. So, if ratings based on past performance aren’t likely to improve your fund choices, what can you do?
Invest with a Purpose
Can you imagine telling your kid that you can’t afford to send them to college next year because you invested their 529 plan money on a hunch that MySpace would become the dominant social media company? That may be a borderline absurd hypothetical, but it illustrates how determining your purpose for investing can go a long way in determining what kind of investment may be appropriate in the first place and how much risk you can take on. A thoughtful plan can also be helpful for reference when the occasional bump in the road causes you to doubt your direction.
Let the Market Work for You
The market is an effective information-processing machine. Millions of market participants buy and sell securities every day and the real-time information they bring helps set prices.
This means competition is stiff and trying to outguess market prices is difficult for anyone, even professional money managers. This is good news for investors though. Rather than basing an investment strategy on trying to find securities that are priced “incorrectly,” investors can instead rely on the information in market prices to help build their portfolios.
You don’t have to try and outsmart the market to be a successful investor. Financial markets have rewarded long-term investors. People expect a positive return on the capital they invest, and historically, the equity and bond markets have provided growth of wealth that has more than offset inflation. Instead of fighting markets, let them work for you.
Play the Odds
Flip a coin and your odds of getting heads or tails are 50/50. Historically, the odds of selecting an investment fund that was still around 15 years later are about the same. Regarding outperformance, the odds are worse. The market’s pricing power works against fund managers who try to outperform through stock picking or market timing. One needn’t look further than real-world results to see this. Based on research*, only 17% of US equity mutual funds and 18% of fixed income funds have survived and outperformed their benchmarks over the past 15 years.
Some investors select mutual funds based on past returns. However, research shows that most funds in the top quartile (25%) of previous five-year returns did not maintain a top-quartile ranking in the following year. In other words, past performance offers little insight into a fund’s future returns.
Academic research has identified several equity and fixed income dimensions, which point to differences in expected returns among securities. Instead of attempting to outguess market prices, investors can instead pursue higher expected returns by structuring their portfolio around these dimensions.
Diversification helps reduce risks that have no expected return, but diversifying only within your home market may not be enough. Instead, global diversification can broaden your investment opportunity set. By holding a globally diversified portfolio, investors are well positioned to seek returns wherever they occur.
Keep Costs Down
With many things in life, you get what you pay for. However, that isn’t normally the case with investing. Real world experience shows that lower costs and turnover correlates to higher returns.
Stay the Course
It’s tough, if not impossible, to know which market segments will outperform from period to period.
Accordingly, it’s better to avoid market timing calls and other unnecessary changes that can be costly. Allowing emotions or opinions about short-term market conditions to impact long-term investment decisions can lead to disappointing results.
Daily market news and commentary can challenge your investment discipline. Some messages stir anxiety about the future, while others tempt you to chase the latest investment fad. If headlines are unsettling, consider the source and try to maintain a long-term perspective.
Whether you choose to go it alone or work with an advisor like ATX Portfolio Advisors, focusing on what you can control can lead to a better investment experience.
1. Invest with a purpose.
2. Let the market work for you.
3. Play the odds.
4. Keep costs down.
5. Stay the course.
 The sample includes US-based funds at the beginning of the 15-year period ending December 31, 2016. Each fund is evaluated relative to the Morningstar benchmark assigned to the fund’s category at the start of the evaluation period. Surviving funds are those with return observations for every month of the sample period. Winner funds are those that survived and whose cumulative net return over the period exceeded that of their respective Morningstar category benchmark.
 At the end of each year, funds are sorted within their category based on their five-year total return. Funds in the top quartile (25%) of returns are evaluated again in the following year based on one-year performance in order to determine the percentage of funds that maintained a top-quartile ranking. The analysis is repeated each year from 2007–2016. The chart shows average persistence of top-quartile funds during the 10-year period.
 US-domiciled open-end mutual fund data is from Morningstar and Center for Research in Security Prices (CRSP) from the University of Chicago. Index funds and fund-of-funds are excluded from the sample. Equity fund sample includes the Morningstar historical categories: Diversified Emerging Markets, Europe Stock, Foreign Large Blend, Foreign Large Growth, Foreign Large Value, Foreign Small/Mid Blend, Foreign Small/Mid Growth, Foreign Small/Mid Value, Japan Stock, Large Blend, Large Growth, Large Value, Mid- Cap Blend, Mid-Cap Value, Miscellaneous Region, Pacific ex-Japan Stock, Small Blend, Small Growth, Small Value, and World Stock. Fixed income fund sample includes the Morningstar historical categories: Corporate Bond, Inflation-Protected Bond, Intermediate Government, Intermediate-Term Bond, Muni California Intermediate, Muni National Intermediate, Muni National Short, Muni New York Intermediate, Muni Single State Short, Short Government, Short-Term Bond, Ultrashort Bond, and World Bond. For additional information regarding the Morningstar historical categories, please see “The Morningstar Category Classifications” at morningstardirect.morningstar.com/clientcomm/ Morningstar_Categories_US_April_2016.pdf. See Dimensional’s “Mutual Fund Landscape 2017” for more detail. Benchmark data provided by Bloomberg Barclays, MSCI, Russell, Citigroup, and S&P. Bloomberg Barclays data provided by Bloomberg. MSCI data © MSCI 2017, all rights reserved. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Citi fixed income indices © 2017 by Citigroup. The S&P data is provided by Standard & Poor’s Index Services Group.